Advisers need to meet the growing expectations of their clients to discuss and provide responsible investment solutions.

The Responsible Investing context

On a global level, the increasing focus of individuals, governments, and businesses, on acting ethically and sustainably has been well documented. This focus has manifested itself across many aspects of society, including government policy, business operations, and institutional and individual investment behaviours, fuelling growth in the responsible investment sector that has outpaced other areas of the market^[1].

This trend has been mirrored in Australia, with recent research^[2] by the Responsible Investment Association of Australasia (RIAA) finding that, during 2020, Responsibly Invested (RI) Assets Under Management (AUM) increased by $298 billion to $1,281 billion, while the AUM in the remainder of the managed fund market decreased by $234 billion to $1,918 billion over the same period.

Underneath the overall RI umbrella fall several investment sub-categories, including ESG-integrated investing, various types of screened investing, and ‘impact investing’ – defined by global asset manager Robeco as “the process of intentionally making investments with the aim of creating a measurable beneficial impact on the environment or society, as well as earning a positive financial return^[3].”

Over the 2020 period, impact investing – a popular form of which is targeting companies that can contribute to the UN’s Sustainable Development Goals (SDGs) – also grew strongly, surging 46% over the year to $29 billion AUM, while the number of impact investing products grew^[4] over this period from 111 to 145.

Drivers of growth

This fundamental reshaping of the investment landscape is no ‘flash in the pan’, with powerful social, economic, and political forces ensuring it will eventually become the prevailing investment orthodoxy around the world.

Government policy

The extent to which political forces are driving this reshaping of investment markets is certainly more pronounced overseas than in Australia, where government policy is relatively less interventionalist.

By way of comparison, whilst Australia has recently committed to net zero carbon emissions by 2050, this is not legislated. In Europe, on the other hand, member states are legally bound to achieve net-zero emissions by 2050, creating a roadmap for investments in technology and infrastructure that has already driven seismic shifts across many industries.

In the car industry for example, the pressure to bring down vehicle emissions has been given extra impetus by the City of London – one of Europe’s biggest car markets – banning the sale of petrol and diesel cars by 2030. On the expectation that other cities will follow suit, many major car manufacturers have stated their intention to transition to Electric Vehicle (EV) only production in the future. The world’s largest car manufacturer – Volkswagen^[5] – have indicated they will go EV only from 2035, whilst Volvo aim to get there 5 years earlier^[6].

The implications, and opportunities, for investors are enormous.

In Australia, the EV tide is slowly starting to turn, with a number of new EV policies coming into effect recently to encourage the uptake across government and non-government fleets. For example, NSW and the ACT waives stamp duty on new zero-emission cars, and South Australia has announced a $13.4 million spend on charging infrastructure. NSW is also currently offering a $3,000 rebate to purchases of new EVs (subject to a cap of 25,000 vehicles).

Of course, with more than half of Australians now considering the purchase of an EV as their next vehicle^[7], the future growth in sales of electric vehicles in Australia will be driven by bottom-up demand as well as top-down policy, reflecting a growing realisation that a more sustainable approach can often benefit the hip pocket as well as the planet. The opportunity to save on power bills, for example, has seen one in four Australian homes instal solar energy sources, the highest uptake in the world, and the main reason that one quarter of all electricity in Australia is now generated from renewable sources^[8].

Consumer expectations

Consumers are also increasingly expecting that their financial services providers will act sustainably and ethically.

RIAA research^[9] from 2019 found that 86% of Australians expect their super or other investments (excluding banking) to be invested responsibly and ethically, and 87% expect the money in their bank accounts to be invested responsibly and ethically.

The same study found that:

• three quarters of Australians would consider moving their banking, super or other investments to another provider if they found out their current provider was investing in companies engaged in activities not consistent with their values
• two thirds (67%) of Australians who don’t currently invest in ethical companies, funds or superannuation funds would be most likely to consider doing so in the next 5 years
• recent weather conditions in Australia have prompted 2 in 5 Australians to think about switching financial institutions (banks, super funds etc.) to one which invests ethically or responsibly
• half of Australians say they would be motivated to invest and save more money if they knew their savings or investments made a positive difference in the world
• 54% of Australians believe their own investment decisions can influence the amount of climate change caused by humans.

Consumers have similarly high expectations of their financial advisers, with 90% expecting their adviser to offer them responsible or ethical investment options, and 86% believing that it is important for their adviser to ask them about their interests and values in relation to their investments.

Demographic differences

Notwithstanding the clear growth in demand for sustainable investing at an aggregate consumer level, several demographic groups exhibit especially strong interest:

• female investors
• younger Investors
• High Net Wealth/Worth (HNW) investors.

Female investors

Various studies have shown female investors – from affluent to HNW – are more interested in social and environmental impact investing than their male counterparts. Morgan Stanley1^[10] found 84% of females to have an overall interest in social impact investing, compared to 67% of males, whilst BCG^[11] found female investors were more likely to rank social responsibility amongst their top 3 investment objectives (Figure 1 below).

Interestingly, female investors are significantly more likely to believe there is a positive association between ESG factors and corporate financial performance^[12], putting them ‘ahead of the curve’ in embracing RI.

Younger investors

As has been witnessed throughout history, the behaviours and attitudes of younger generations towards concepts such as career, relationships, and public institutions, are usually markedly different from their forebears. This is also true in investing, where their heightened concerns around the environment, equality, and social justice translate into significantly higher interest in RI.

For example, Bloomberg^[13] measured millennials’ interest in social impact investing at 77%, compared to just 35% for Baby Boomers. In Australia, investors under 25 were found to be twice as likely as retirees to name ESG/ethical considerations a top three investment consideration^[14]. Figure 2, based on US research, shows a similar generational difference in expectations around ESG screening of investments.

HNW investors

According to Capgemini, the world’s wealthy are increasingly putting their money towards socially, ethically, and environmentally conscious businesses, which could spur the growth of sustainable investments.

In their 2020 World Wealth Report^[16] more than a quarter (27%) of high-net-worth individuals (those with investible assets of $1 million or more) said they were interested in sustainable products. That figure rose to 40% among ultra-high net worth individuals (UHNWIs), those with $30 million or more to invest.

The same report found that their interest is translating into action, with wealthy investors planning to allocate 41% of their portfolio to businesses actively pursuing environmental, social, and corporate governance (ESG) policies by the end of 2020, rising to 46% by the end of 2021.

Almost half the respondents to an Australian survey^[17] of HNW investors said they now choose funds or companies to invest in according to environmental, social and governance (ESG) considerations. More than half (54%) said they avoided investing in companies with controversial track records, while a massive 89% said that fund managers should ‘police’ companies to ensure they act responsibly.

Investor motivations

Whilst a desire to invest in line with personal values, ‘give back’, and ‘make a difference’ to society, are common motivators for individuals to invest in RI products, they are not the only ones. And there are also significant differences in the specific issues targeted by investors for impact.

At an overall level, environmental issues are closest to the hearts of Australian investors, as shown in Figure 5. Renewable energy, sustainable water management and healthy river and ocean ecosystems are the top three priority environmental issues, and healthcare and education the key social issues.

In terms of preferred ways to impact the environment, differences are apparent across generations. Millennials (25-39 y.o), for example, feel clean and renewable energy sources have the most impact, whilst those aged under 25 feel energy consumption reduction should be the key priority. All other age groups prioritised recycling of non-biodegradable waste as the most important^[19].

‘Traditional’ investor objectives – performance and risk management

Perhaps ironically – and contrary to the perception (now lessening) that sustainable investing comes at the cost of lower returns – the biggest catalyst to propel the growth of sustainable investing in Australia may well lie in traditional investment metrics – performance and risk management. Indeed, smart investors have already figured out that sustainable companies are generally better managed and less susceptible to governance failures, and as a result tend to perform better. Similarly, ‘sustainable’ industries are less likely to be negatively impacted by regulatory intervention or falling consumer demand, and also therefore represent better long-term investments.

Consistent with this, research by Capgemini^[20] found expectations around superior performance to be the number one driver of increased demand by HNW investors in ESG investments, cited by 39% of respondents. Financial returns are also a top 3 motivator for impact investing across various categories of individual, corporate and institutional investor, according to the RIAA (Figure 4).

And their confidence is warranted.

Overseas, Morgan Stanley^[22] notes that sustainable funds outperformed traditional peers and reduced investment risk during 2020. Locally, tracking by the RIAA has confirmed the extent to which responsible investment options have outperformed mainstream offerings, over both the short and long term^[23].

Against the economic setback of Covid-19, responsible investment funds outperformed both international share and multi-sector growth funds in 2020 and performed on par with the Australia Fund Equity Large Blend category, as shown in Figure 5, below.

Drilling down further into specific RI categories, portfolio level data from Robeco^[24], which includes Covid market corrections, showed credit investments rated as SDG positive delivered higher performance and lower risk than those with neutral or negative ratings over the 5 years to August 2019 (see Figure 6 below).

BFID, Fiduciary duty and sustainable investing

Recognition that socially responsible investment is consistent with delivering sound financial outcomes is seen in the embedding of ESG considerations in fiduciary obligations for pension fund managers in Canada, the UK and Europe.

In Europe, for example, the Swedish parliament introduced reforms in 2018 requiring the four main national pension funds to become “exemplary” in the field of sustainable investment^[25]. Mercer^[26] estimates suggest 54 per cent of all European Pension Funds are taking climate change into consideration.

In Australia there is no such policy mandate, although many larger superannuation funds are building more sustainable investment frameworks. Whilst this is generally proactive, in some cases strengthening these frameworks are a reaction to member agitation, as was the case with Rest Super, recently sued by a member over its lax approach to climate risk^[27].

Some funds have specifically sought to align their investment approach with the SDGs, although all have approached the task differently. Australian Super, for example, has participated in the development of a platform for assessing the SDG impact of individual companies^[28]. HESTA^[29] has chosen seven SDGs to align its portfolio with: good health and wellbeing, gender equality, clean water and sanitation, affordable and clean energy, climate action, sustainable cities and communities, and decent work and economic growth. NGS Super lists all 17 SDGs on its website and details the contribution it is making towards each through its investing practices and staff action.

Australia’s recent superannuation reforms included the introduction of a Best Financial Interests Duty for superannuation trustees. Given the body of evidence around financial performance, such a duty should strengthen, rather than undermine, the ability of trustees to allocate more funds to sustainable investments.

ASIC ‘greenwashing’ review

The growing consumer interest in sustainable investing makes the spruiking of green credentials a very powerful marketing tool. Unfortunately, there is often a lack of transparency in the link between investments made and outcomes achieved, which companies can exploit by falsely claiming ‘green’ credentials.

The potential for funds to overrepresent the extent to which their practices are environmentally friendly, sustainable, or ethical is referred to in the market as ‘greenwashing’.

Greenwashing is very much an issue in Australia, with the RIAA estimating only about one quarter of the investment managers who say they invest responsibly can actually prove their credentials^[30].

There is growing global unease about the risks of greenwashing of financial products, and international regulators have established a Sustainable Finance Task Force that covers greenwashing and other investor protection concerns. ASIC is participating in this task force, and in July 2021 they announced their intentions to conduct a review of environmentally focused investment funds in Australia^[31].

Best practice transparency

Advisers seeking to offer responsible investment solutions to their clients should prioritise those investments and fund managers who are able to comprehensively demonstrate their social and/or environmental impact.

One example of best practice in this area is global asset manager Robeco, who in Australia offer an SDG-aligned credit income strategy.

For the SDG Credit Income strategy, Robeco publishes monthly reports on how the portfolio contributes to the SDGs. As can be seen from Figure 7, an extract from the February 2021 report³², the portfolio contributes the most to SDG 1 (no poverty), SDG 7 (affordable and clean energy), SDG 8 (decent work and economic growth), SDG 9 (industry, innovation & infrastructure), SDG 11 (sustainable cities and communities) and SDG 12 (responsible production and consumption).

Conclusion

In the long run, the desire of future generations to make an impact, the evolution of government policy, and improvements in our ability to map the impact of investments against sustainable indicators will ensure that responsible investing becomes the norm, and terms like ‘responsible’, ‘ethical’ and ‘ESG’ will become redundant.

As we have demonstrated across the three articles in this series, SDG-aligned impact investing is a rapidly growing area, largely driven by consumer demand, and reflecting societal trends and evolving policy frameworks. Consumers increasingly expect their financial adviser to discuss their personal values with them and be able to discuss and offer investment solutions aligned to these values. Advisers should equip themselves to have such discussions now – not to get ahead of the game, but simply to keep up with the way the world is changing.

———

References
[1] https://www.morningstar.com/articles/903495/the-continued-growth-of-sustainable-investing
[2] https://responsibleinvestment.org/wp-content/uploads/2021/09/Responsible-Investment-Benchmark-Report-Australia-2021.pdf
[3] https://www.robeco.com/me/key-strengths/sustainable-investing/glossary/impact-investing.html
[4] https://responsibleinvestment.org/wp-content/uploads/2021/09/Responsible-Investment-Benchmark-Report-Australia-2021.pdf
[5] https://www.cnet.com/roadshow/news/volkswagen-all-electric-ev-europe-us/
[6] https://www.media.volvocars.com/global/en-gb/media/pressreleases/277409/volvo-cars-to-be-fully-electric-by-2030
[7] https://www.savings.com.au/news/esg-investing-push
[8] Ibid
[9]  https://responsibleinvestment.org/wp-content/uploads/2020/03/From-Values-to-Riches-2020-full-report.pdf
[10] https://www.triplepundit.com/story/2019/esg-and-impact-investing-more-women-are-leading-charge/83131/
[11] https://www.bcg.com/en-au/publications/2020/managing-next-decade-women-wealth
[12] https://www.intuition.com/sustainable-investing-3-primary-drivers-for-esg-investments/
[13] https://www.oliverwyman.com/content/dam/oliver-wyman/v2/publications/2019/aug/impact-investing-in-asia_16sep.pdf
[14] https://www2.asx.com.au/content/dam/asx/blog/ASX-Australian-Investor-Study-2020.pdf
[15] https://insight.factset.com/the-importance-of-esg-investing-for-hnwis
[16] https://www.cnbc.com/2020/07/10/capgem-world-wealth-report-billionaires-invest-in-sustainability-esg.html
[17] https://www.netwealth.com.au/web/insights/how-to-attract-and-retain-high-net-worth-clients/
[18] https://responsibleinvestment.org/wp-content/uploads/2020/03/From-Values-to-Riches-2020-full-report.pdf
[19] https://www.eco-business.com/press-releases/australian-ethical-research-climate-change-now-1-driver-for-esg-investors/
[20] https://www.cnbc.com/2020/07/10/capgem-world-wealth-report-billionaires-invest-in-sustainability-esg.html
[21] https://responsibleinvestment.org/wp-content/uploads/2020/06/Benchmarking-Impact-2020-full-report.pdf
[22] https://www.investordaily.com.au/analysis/49643-will-australia-follow-the-european-sustainable-investment-boom
[23] https://responsibleinvestment.org/wp-content/uploads/2021/09/Responsible-Investment-Benchmark-Report-Australia-2021.pdf
[24] https://www.robeco.com/au/insights/2020/11/the-link-between-esg-and-performance-sdg-credits-stands-the-test.html
[25] https://hbr.org/2019/05/the-investor-revolution
[26] https://www.investordaily.com.au/analysis/49643-will-australia-follow-the-european-sustainable-investment-boom
[27] Ibid
[28] https://www.australiansuper.com/investments/investment-articles/2020/07/sustainable-development-investments-platform
[29] https://www.top1000funds.com/2019/06/hesta-maps-investments-against-sdgs/
[30] https://www.smh.com.au/money/investing/pressure-mounts-on-funds-to-come-clean-on-being-green-20211007-p58xzb.html
[31] https://mozo.com.au/share-trading/articles/asic-to-review-esg-funds-for-greenwashing
[32] https://www.robeco.com/au/insights/2021/09/our-guide-to-investing-in-sdg-credits.html

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How to identify investable opportunities arising from SDGs, especially in the retail investor space.

Introduction

The Sustainable Development Goals are 17 objectives for improving human society and ecological sustainability adopted by the United Nations in 2015. They cover a broad spectrum of sustainability topics, ranging from eliminating hunger and combating climate change to promoting responsible consumption and making cities more sustainable.

Critically, these weren’t goals left in the hands of governments alone to initiate, and the UN has called on business, corporates, and individuals to also play their part. Despite this call, there has been a persistent SDG financing gap estimated at around $2.5 trillion per annum^[1].

Fortunately, SDG aligned investing is growing rapidly, in line with growing investor appetite for impact investments more broadly.

Whilst early innovations in impact investing have mainly catered to institutional investors, the next frontier for impact investing – including SDG aligned investing – lies with retail investors, who globally command around $100 trillion in investing power^[2].

In order to understand what the future of SDG aligned investing looks like, it is necessary to understand both the challenges in creating investable opportunities from the SDGs, as well as the motivations of investors seeking to make an impact with their investments. Within this context, we can then explore product innovation trends in this space, the opportunities for investors, and the implications for financial advisers.

The SDG investing challenge

There are a number of major challenges into creating investment opportunities that progress the SDGs.  Firstly, it is not always straightforward to be able to measure the link between economic activity and SDGs. Secondly, and related to the first point, the individual companies behind this economic activity can both positively and negatively impact any one of the 17 SDGs and their 169 underlying targets, making it difficult to assess their ‘net impact’. Thirdly, many of the high-level goals themselves don’t automatically present as investable.

Economic activity and SDGs

In societies, companies undertake numerous types of economic activities, which sustain livelihoods and produce goods and services that help people attain a better life, but which can also have negative consequences.

Different types of economic activities can impact different SDGs, however, there has been a general shortage of evidence on how individual economic activities interact with the SDGs. This lack of evidence adds a layer of complexity for companies, governments, and investors trying to create smart SDG strategies that steer towards net positive impact.

A recent study^[3], by academic Rob Van Tulder and Robeco SDG strategist Jan Anton van Zanten, shed new light on this problem.

At an overarching level, their study found that economic activities bring ample opportunities for advancing the SDGs, as most are sources of economic productivity, which directly benefit SDG 8 (decent work and economic growth) and/or SDG 9 (industry, innovation, and infrastructure).

However, widespread negative impacts were identified, especially afflicting ecosystems reflected by SDG 14 (life below water) and SDG 15 (life on land). Others were found to be bad for global warming, adversely impacting SDG 13 (climate action), or they harm human health SDG 3 (good health and well-being).

Agricultural activities, for instance, feed the world, thereby having clear potential to help achieve SDG 2 (zero hunger), however, they also account for 70% of water withdrawals globally which raises concerns for SDG 6 (water and sanitation), and the use of fertilizers and pesticides threatens SDGs 14 and 15 (life on land and below water).

Electricity generation promotes SDG 9 (industry, innovation, and infrastructure), but when it is generated through non-renewable sources, SDG 13 (climate action) is at risk, while SDG 3 (health and well-being) may be harmed due to air pollution. Estimates suggest that in China, for example, 15 million years of life that is lost through pollution from power generation could be avoided.

The Van Tulder and van Zanten study observed an increasing recognition amongst scientists and policymakers that SDG progress could be accelerated through a ‘nexus approach^[4]’. This nexus approach aims to identify and manage interactions between SDGs such that multiple SDGs can be advanced simultaneously, whilst mitigating the risk that progressing one will undermine another.

For example, eradicating hunger (SDG 2) improves health and well-being (SDG 3) and can help people escape poverty (SDG 1). Targeting these SDGs together, instead of treating them as isolated silos, brings opportunities for bigger impacts.

Making SDGs investable

At a high level, the investment opportunities underlying many of the SDGs are not that obvious. Where, for example, do the opportunities lie with SDG 14 (Life below water), or SDG 16 (peace, justice, and strong institutions)?

To answer this question, we must look to the targets underlying each goal, along with the UN defined progress indicators for each goal. Across the 17 SDGs there are 169 targets and 232 unique progress indicators^[5], and it is the granularity of these goals and measures which helps illuminate the potential investment opportunities.

Using SDG 14 as an example, there are 7 underlying targets, each with its own corresponding indicators^[6]. Focusing on a subset of these targets, Table 1 below shows how these can manifest as investment opportunities.

Frameworks to bring it all together

Creating a universe of appropriate investment opportunities from SDGs requires us to connect the investment potential of SDGs with the activities of individual companies, and as discussed in our first article in this series, there are a number of frameworks that have been developed for this purpose.

Robeco’s proprietary framework^[7] is one such example.

The first step in their framework is to link companies’ products and services to the SDGs. To what extent do they contribute? Companies are assessed on an extensive set of rules and Key Performance Indicators (KPIs). These are summarized in a guidebook. The guidebook states whether – as a starting point – the contribution of these products and services is positive, neutral, or negative.

For the telecom sector, for example, the starting point is positive. Telecommunications are an essential part of the infrastructure in a safe and connected society. Farmers can use mobile phones to check market prices before selling to middlemen, and market traders can accept payments in mobile money. This way, the telecom sector can contribute to a proper infrastructure (SDG 9), economic growth (SDG 8) and ultimately to the reduction of poverty (SDG 1).

Next, the degree of that contribution has to be determined.

Whilst under the Robeco framework this defaults low in the case of Telcos, closer examination of individual companies within the sector, and assessment against a set of proprietary KPIs may reveal outliers. If, for example, more than 25% of the Telco’s sales take place in emerging markets (which have most to gain from a good telecom network) they will upgrade the impact from positive-low to positive-medium.

The second step is to assess how the companies operate themselves. Are they polluting, do they respect labour rights, do they refrain from corruption? Ratings are then adjusted accordingly.

Robeco’s final step is to check whether the company concerned has been involved in any controversies, such as oil spills, fraud, or bribery. This step can lead to adjustments in the rating. If firms commit serious and structural breaches of the UN Global Compact, for example, they are excluded.

When this framework was applied to a sample^[8] of 450 companies, 62% of the companies have been assessed as making a positive SDG contribution. These included grid operators, healthcare companies, banks (by providing finance, especially in emerging markets, banks play an important role in fostering innovation and stimulating economic growth) and utilities with a relatively small share of coal, nuclear energy, and oil in the energy generation mix.

26% of the companies assessed were found to make a negative contribution, including energy producers with a relatively large share of fracking, companies that produce unhealthy food, or car manufacturers with a low share of EV/hybrid models.

How does this translate into investment opportunities?

The SDGs have broadened the scope of impact investments from traditional and mostly private impact investing vehicles, such as microfinance funds or renewable energy projects, to listed equities and credits, as well as thematic strategies.

Thematic or issue investing

Three examples of investment strategies that target an issue rather than a specific SDG, can be seen in themes that are gaining traction in environmental protection: renewable energy, the circular economy, and green bonds:

Renewable energy

Renewable energy is a genre of investing in its own right that now straddles impact investing and mainstream sustainable investing. Once considered niche, the solar, wind and hydroelectric power industries have become an important part of the international energy mix, accounting for 28% of global energy production in 2020^[9]. Investing in renewables, however, is often done indirectly through more mainstream investing.

Circular economy

2020 saw the launch of several funds targeting the circular economy. These aim to replace the current ‘take-make-dispose’ model of production and consumption, which relies on the continual use of resources. To this end, such funds invest in companies engaged in activities starting with ‘re’: recycle, reuse, refurbish, repair, redesign, recover. There is no specific SDG for the circular economy – although it ties in with SDG 12 (responsible consumption and production).

Green bonds

Green bonds are debt securities that are exclusively used to promote environmental projects. They are issued mainly by governments, municipalities, and NGOs. For a bond to qualify as ‘green’, its proceeds should be used for projects with clear environmental benefits, such as renewable energy or waste management. The first green bond was a Climate Awareness Bond issued by the European Investment Bank in 2007, and it is becoming increasingly mainstream, with an estimated EUR 700 billion in green bonds now in circulation^[10].

Listed equity and credit strategies

Investors wanting an approach more directly linked to SDGs may seek out equities or bonds of companies that are demonstrably making a positive contribution to achieving one or more of the 17 goals.

Australian research^[11] suggests most investors are equally happy to access such strategies either directly through the underlying instruments, or via managed funds based on these strategies, and to the extent this view is mirrored by investors around the world, it has driven a great deal of product innovation, especially at the retail investor level.

In the direct investment space, some of the innovation has occurred through the development of platforms that make such investments more accessible.

US based CNote^[13], for example, allows retail investors to crowdfund impact investments in increments as small as $1.50, whilst in the UK, several asset managers have partnered with the Big Issue to create the Big Exchange platform^[14], which offers a choice of around 30 environmental impact funds.

In terms of the managed fund approach, global asset manager Robeco is one of the pioneers in this space and has been offering SDG linked credit strategy products for several years. These strategies, one of which is now accessible to Australian investors, are based exclusively on bonds that, using Robeco’s own framework (described above), have been assessed as having an SDG score of 0 (neutral) or higher. The strategies do not invest in companies that detract from the SDGs. As such, the strategies are designed to make a clear contribution to the SDGs while also aiming to outperform a mainstream corporate bond index or optimize yield and income.

Impact alpha

As discussed extensively in the first article in this series, despite perceptions to the contrary, impact investing does not come at the cost of investment performance.

In fact, some experts^[15] make an argument that, by considering impact in the investment process, you can actually do better financially; what’s termed ‘impact alpha’.

Portfolio level data from Robeco^[16], which includes Covid market corrections, showed credit investments rated as SDG positive delivered higher performance and lower risk than those with neutral or negative ratings over the 5 years to August 2019 (see Figure 2 below).

The role of governments in growing the impact investing sector

Many governments have recognised the role they can play in fostering a vibrant, effective, and accessible market for impact investing.

The UK government for example, has been clear that the supply of retail impact investment products is failing to meet demand, and has pledged to work with leaders in the investment and savings industry to make social investment more accessible to the everyday investor.

In Australia, the Commonwealth Government has several measures in place to support the development of the domestic social impact investment market, although to date their focus hasn’t been at the retail investor level.

2017 saw the launch of the Australian Government Principles for Social Impact Investing, and since the 2017-18 Budget^[18], the Commonwealth has announced $57 million in initiatives, including:

• partnering with state and territory governments on social impact investing projects
• developing a Sector Readiness Fund to grow the social impact investing market by providing capability-building grants to impact businesses looking to become investment ready
• building the capacity of the Australian social impact investing sector to measure its outcomes and impacts
• co-designing, implementing, and evaluating payment-by-outcome funding trials in the social services sector, and
• overseeing a number of social impact investing programs that advance the interests of Aboriginal and Torres Strait Islander people, in particular through Indigenous Business Australia (IBA).

The future

Whilst impact investment products (of which SDG aligned investing is a subset) currently account for around $20 billion in FUM (across around 110 products), the potential demand from investors over the next 5 years has been estimated at $100 billion^[19].

Innovations in technology and products, coupled with an evolving level of sophistication in measuring and reporting the environmental and social impact of investments will help make SDG aligned investing far more accessible to retail investors.

As the sector grows, Advisers must ensure they develop and maintain a contemporary understanding of its high-level dynamics, the range of solutions available within it, and the evolving motivations of individual investors driving this growth.

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References:
[1] https://oecd-development-matters.org/2020/01/22/how-blended-finance-can-plug-the-sdg-financing-gap/
[2] https://www.rockefellerfoundation.org/report/individual-imperative-retail-impact-investing-uncovered/
[3] https://www.robeco.com/au/insights/2020/06/linking-economic-activities-with-the-sdgs.html
[4] Ibid
[5] https://sdg-tracker.org/
[6] https://unstats.un.org/sdgs/indicators/Global%20Indicator%20Framework%20after%20refinement_Eng.pdf
[7] https://www.robeco.com/au/insights/2018/05/how-to-quantify-a-companys-contribution-to-the-un-sdgs.html
[8] Ibid
[9] https://www.iea.org/reports/global-energy-review-2020/renewables
[10] https://www.robeco.com/au/essentials/sdg/
[11] https://responsibleinvestment.org/wp-content/uploads/2020/06/Benchmarking-Impact-2020-full-report.pdf
[12] Ibid
[13] https://www.mycnote.com/
[14] https://bigexchange.com/
[15] https://www.rockefellerfoundation.org/report/individual-imperative-retail-impact-investing-uncovered/
[16] https://www.robeco.com/au/insights/2020/11/the-link-between-esg-and-performance-sdg-credits-stands-the-test.html
[17] Ibid
[18] https://responsibleinvestment.org/wp-content/uploads/2020/06/Benchmarking-Impact-2020-full-report.pdf
[19] Ibid

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Investors are increasingly seeking out investment solutions that allow them to earn both a financial and a social return.

Introduction

Since the start of 2020, investment markets around the world have experienced a surge of activity. But while most headlines focused on the influx of boredom-fuelled retail investors into equity markets, other investment categories have also witnessed a growth in interest and activity.

One such category is the impact investing market, which has continued to mature and is now worth more than $1 trillion globally^[1]. Motivated not by boredom, but by an increasing awareness and desire to act in areas such as climate change, access to healthcare, and racial and gender inequality, investors are increasingly seeking out investment solutions that allow them to earn both a financial and a social return.

In Australia, the potential demand from investors over the next five years for impact investment products could be as high as $100 billion^[2], and with 9 in 10 Australians^[3] believing it’s important for their Financial Adviser to offer responsible or ethical investment options, now is an ideal time for advisers to prepare for these client conversations by deepening their understanding of impact investment offerings, in particular those aligned to Sustainable Development Goals (SDGs), the most widely used framework for measuring and communicating impact.

Sustainable development goals explained

In 2015 the United Nations issued a landmark agenda designed to propel the globe into a more prosperous, sustainable and environmentally friendly future by the year 2030.

The Sustainable Development Goals (SDGs) are 17 objectives for improving human society, ecological sustainability and the quality of life. They cover a broad spectrum of sustainability topics, ranging from eliminating hunger and combating climate change to promoting responsible consumption and making cities more sustainable.

All countries – no matter how rich or poor – have agreed to work towards achieving the 17 SDGs by 2030, thereby establishing a 15-year timeframe for progress.

Critically, these weren’t goals left in the hands of governments alone to initiate, and the UN called on business, corporates and individuals to also play their part.

Measurability

The 17 goals have 169 underlying targets and 232 approved indicators, which are used to track progress towards achieving them. For example, the targets for SDG 3 (good health and well-being) aim to end premature mortality, halt the spread of communicable diseases such as malaria and HIV/AIDS, and promote the attainment of affordable universal health coverage. The indicators measure such factors as a country’s child mortality rate, the number of new malarial or HIV infections, and the number of people covered by health insurance.

In terms of tangible investing, health care companies can contribute to SDG 3 by developing drugs that combat certain diseases, or by improving people’s access to affordable medicines. Conversely, some companies may negatively contribute to the SDGs, by producing harmful products such as tobacco or firearms.

Investing with impact via the SDGs

Impact investing is the process of intentionally making investments with the aim of creating a measurable beneficial impact on the environment or society, as well as earning a positive financial return.

Impact investing has three key components:

• intentionality: an investor sets out to exert a positive impact
• return: it should generate a positive return on the investment
• measurability: the benefits should be measurable and transparent.

Some investors believe that impact investing should also incorporate the concept of ‘additionality’, which involves only allocating to businesses that they would not otherwise have chosen to invest in if they were not seeking to achieve a positive social impact.

Once considered a niche form of investing, the high measurability of progress towards the SDG goals, along with the obvious appeal of investing in ways which can make a positive difference across so many different facets of life (not just single issues like climate change), have seen SDG aligned investment products become an important and growing sub-category of impact investing.

How SDG aligned investing is different to ESG investing

SDG aligned investing seeks to make a difference ‘on the ground’, for example through the eradication of poverty (SDGs 1,2) and reducing inequalities in society (SDGs 5,10) through investment capital rather than charity.

ESG investing, on the other hand, applies environmental, social and governance (ESG) factors in a way intended to minimize the negatives that come with all corporate activity.

This can be done by avoiding companies with poor environmental records or involvement in corruption. But it doesn’t necessarily have to make an impact on the ground; finding the companies with the highest ESG score compared to peers won’t directly contribute to education or health in Africa. Most notably, a tobacco company can have a very high ESG score – for example for having good governance practices and gender diversity – but clearly contributes negatively to SDG 3 for good health and well-being.

Which SDGs are companies and investors attracted to?

While contributing to the SDGs presents a clear opportunity for businesses and investors, some goals pose more challenges than others, and as a result, opinions differ on the preferred goals to invest in.

In Australia, a survey of investors^[5] (shown in Figure 2, below) revealed that, while impact investments were spread across all 17 SDGs, there were some clear standouts, with SDG 7 – affordable and clean energy (10%), SDG 11 – sustainable cities and communities (9%), SDG 3 – good health and wellbeing (8%), and SDG 13 – climate action (8%), ranking the highest.

How to assess companies for SDG aligned portfolios

Some companies, by their nature, will be more attuned to making a contribution to SDGs than others.

For example, there can be no doubt that a company producing solar energy is contributing to SDG 7 (affordable and clean energy). Similarly, a business creating educational materials for schools is directly contributing to SDG 4 (quality education), while a firm that actively works to promote women in leadership roles is advancing SDG 5 (gender equality).

But theoretically there is no reason why a business in any sector can’t explicitly map their corporate activities to the SDGs, incorporate them into their strategic objectives, and transparently report on their progress.

One such example is South 32, a Perth based resources company spun out of BHP in 2015. On their website, they set out the 11 of 17 SDGs they are committed to, and the action they are taking to meet them. Examples are shown in the Case Study, below.

However, such alignment between corporate goals and activities and SDGs – and such transparency – is still the exception rather than the rule, and investors seeking to assess individual companies in terms of their SDG contribution face a number of challenges.

Some companies, for example, have negative impacts on the SDGs. This might be obvious in some cases, where harmful products such as cigarettes are produced. But other companies may contribute both positively and negatively. How should investors categorize, for example, an energy utility that uses both wind power and thermal coal?

Even more complex challenges arise with the creation of products or services that advance SDGs but simultaneously generate negative externalities. For example, mining metals that are crucial for the manufacture of electric cars or wind turbines, also adversely impact ecosystems and emit greenhouse gases.

For these reasons, investors must rely on various models and frameworks to assess the overall SDG merits of individual companies when deciding on their inclusion in equity or corporate bond portfolios.

A number of methodologies have evolved in recent years, including the SDI Asset Owner Platform, developed by Dutch Pension Funds APG and PGGM. This methodology breaks SDGs down into investible sub-goals and then measures how much of the company’s operations contribute to these investible subgoals. They do this by using financial or operational metrics such as the proportion of revenues derived from a certain SDG-friendly activity.

Another framework is that developed by international asset manager, Robeco.

Their proprietary SDG Impact Framework^[8] provides research for bespoke investment strategies targeting all 17 goals.

The methodology uses a three-step process to ascertain companies’ sustainability credentials:

• Step 1: What does the company produce? Analysts look at what the company produces to determine whether this contributes positively or negatively to the relevant SDGs, using specific key performance indicators and thresholds.
• Step 2: How does the company produce? Here, analysts examine how these goods and services are produced and whether these companies advance SDGs in their operations, or whether there are any flipsides to apparent good intentions, such as poor governance.
• Step 3: Has the company erred? Checks are made to see whether the company has been involved in any controversies. Examples include pollution incidents or the mis-selling of services.

Scores are then assigned to assess a company’s overall impact. These range from +3 (highly positive) to -3 (highly negative). Robeco can then make investment decisions for its SDG aligned products based on these scores.

Figure 3 Below represents this approach more graphically.

How can individuals invest in SDGs?
Individuals wishing to invest in SDGs have a number of options available to them, including equity or credit strategies that exclusively target the SDGs, and more thematic strategies that target a theme related to the SDGs, such as renewable energy.

The number of SDG specific offerings is currently small, but growing, in line with accelerating demand for these kinds of strategies. Such offerings are based on portfolios of bonds and equities of companies that are demonstrably making a positive contribution to achieving one or more of the 17 goals, as assessed through one of the methodologies discussed above.

Instead of taking a targeted SDG approach, some impact funds target a specific issue or theme, such as reducing plastic pollution. The investor is therefore contributing to its associated goals – in this case SDGs 11, 12, 14 and 15.

Three examples of investment strategies that target an issue rather than a specific SDG, can be seen in themes that are gaining traction in environmental protection: renewable energy, the circular economy, and green bonds.

In Australia, the total value of impact investment products as of 31 December 2019 that are widely offered to Australian investors had grown 249% to $19.9 billion (including $8 billion in foreign domiciled products), over the previous 2 years. This was represented by 111 products^[10].

Busting the performance myth

Whilst sceptics maintain the line that responsible investing comes at the cost of performance, the data belies this, showing it really is possible to ‘do well by doing good’.

Respondents to the 2020 Australian Impact Investment Survey report that overwhelmingly (92%) their impact investments are meeting or exceeding their financial return expectations^[11].

And nor is this because of lower expectations. The same survey found the financial return expectations among Australian impact investors are high, with three quarters of investors expecting competitive or above market rates of return on their impact investments.

In 2015 Cambridge Associates, in collaboration with Global Impact Investment Network (GIIN), introduced the Impact Investing Benchmarks. Together they produce quarterly reports that specifically capture the performance of private equity and venture capital funds that target risk-adjusted market-rate returns in the impact investing space (as opposed to funds that target concessionary returns that are perceived to be below market rate).

According to the GIIN’s 2017 study, ‘Evidence on the Financial Performance of Impact Investments’, socially responsible funds generated aggregate net returns in a range that was similar to that achieved by conventional investing^[12].

Reinforcing these findings are the trends seen when comparing traditional equity indices with socially responsible investment indices.

The MSCI KLD 400, which was founded as the Domini Social Index, was established in 1990 and consists of 400 companies that meet rigorous standards for environmental excellence and social responsibility. Over the past 30 years, it has tracked performance of these companies against the S&P 500. As can be seen below, the social index has consistently outperformed traditional stocks for the past 25 years. And this gap continues to grow.

Adviser implications

Growing investor expectations for investments to make a difference continue to drive strong growth in demand for impact investment solutions. An important, and increasingly popular form of impact investment is SDG aligned investing – credit and equity products aligned to the United Nation’s 17 Sustainable Development Goals.

The growing range of SDG aligned solutions includes those targeting specific SDGs (e.g., health, education, climate control) and those that are more thematic based (e.g., reducing plastic pollution). More products are being introduced to the market regularly.

In light of this, financial advisers need to:

• understand and be able to explain the concept of SDG aligned investments to clients and prospects
• understand the methodologies used by fund managers in assessing SDG contributions of individual companies when constructing equity and credit portfolios, and
• understand the performance expectations and experiences of active impact investors.

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References:
[1] https://probonoaustralia.com.au/news/2020/06/global-impact-investment-market-tops-1-trillion/
[2] https://responsibleinvestment.org/wp-content/uploads/2020/06/Benchmarking-Impact-2020-full-report.pdf
[3] Ibid.
[4] https://sdgs.un.org/goals
[5] https://responsibleinvestment.org/wp-content/uploads/2020/06/Benchmarking-Impact-2020-full-report.pdf
[6] Ibid.
[7] https://www.south32.net/sustainability-approach/sustainable-development-goals
[8] https://www.robeco.com/au/key-strengths/sustainable-investing/sustainable-investing-research/robecosam-sdg-score.html
[9] https://www.robeco.com/au/essentials/sdg/
[10] https://responsibleinvestment.org/wp-content/uploads/2020/06/Benchmarking-Impact-2020-full-report.pdf
[11] Ibid.
[12] https://www.mycnote.com/blog/does-impact-investing-have-lower-returns/
[13] Ibid.

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Factor investing is underpinned by the premise that the performance of a portfolio is often largely attributable to the presence of one or more observable ‘factors’ or characteristics, rather than the skill of the individual fund manager.

In article one of this two-part series Factor investing – an introduction^[1], we introduced the concept of factor investing, exploring its origins and academic basis, the nature of commonly used factors, and the various ways investors can access factor-based strategies.

In this second part we take a more in-depth look at factor investing in action, exploring the effectiveness of factor strategies across regions, asset classes and business cycles. We also examine the shortcomings of ‘generic’ factor approaches and consider optimal ways to ‘combine and harvest’ factor premia.

Factor investing – a brief recap

Factor investing is underpinned by the premise that the performance of a portfolio is often largely attributable to the presence of one or more observable ‘factors’ or characteristics, rather than the skill of the individual fund manager. Examples of these factors – known as factor premia – include Low Volatility, Value, Quality, and Momentum.

As well as its extensive academic grounding, the effectiveness of factor investing is supported by overwhelming quantitative evidence, and as a result, factor investing continues to grow in popularity, accounting for more than USD 1.5 trillion in invested assets^[2], and experiencing an average growth rate of 17% per annum since 2010.

Factor performance – a deeper dive

The increasing popularity of factor strategies is driven largely by the strong body of evidence around the historical outperformance of factors, relative to the market. Of course, not all factors are created equally, and nor do they perform in the same way at the same time. Unlocking the power of factor investing necessitates more understanding of how factors have performed across different business cycles and market phases. To help illustrate this, Figure 1 depicts the performance of five widely accepted factors over the last 20 years^[3], whilst Figure 2, identifies which factors tend to excel across different phases of the economic cycle, as defined by the rate of economic growth^[4].

During times of economic recovery – characterised by weak or accelerating growth – smaller, more agile companies tend to perform better, as do Value stocks that are already trading at a discount.

As would be expected, Momentum strategies have excelled during long running bull markets (as can be seen from 2009 onwards in Figure 1) but have tended to lose some of their lustre in recessions.

Quality stocks with stronger balance sheets – more defensive in nature – have tended to perform best at the peak of an economic cycle, when growth is strong but decelerating, or at the very beginning of a slowdown.

Once in the midst of a crisis/recession, Quality and Low Volatility factor strategies have worked particularly well.

Another key concept in comparing factor performance in different economic regimes is the ‘spread’ between high and low relative performance. In this context, spread can serve as a quantitative proxy for an active managers’ ability to generate excess return by deviating from the market.

Typically, as economic growth takes hold and consumer confidence rises (represented by the recovery phase seen in Figure 2), the market places less emphasis on differentiation between managers and stocks, and the ‘spread’ tends to get smaller. A rising tide lifts all boats, as the saying goes. Conversely, in difficult times when market returns are on average negative or the future is uncertain, the ability to generate positive return is predicated on an investor’s skill of choosing wisely, and spreads tend to expand.

This tendency for Factor spreads to expand in and around recessions, suggests there is greater potential for disciplined active managers to deliver outperformance during those periods.

COVID 19 and Factor Investing

Discussion of any aspect of investment strategy would clearly be incomplete if it failed to acknowledge the impact of the COVID 19 wrecking ball on economies around the world.

Whilst the different status of the virus in different countries makes it hard to assess the short term outlook for economic recovery, and the recent resurgence in markets – unsupported by fundamentals – is downright confusing, factor performances in the lead up to, and following the declaration of, the COVID 19 pandemic, unsurprisingly exhibited an overwhelming desire for safety, and the avoidance of specific sectors (e.g. consumer discretionary, financials).

Amid the widespread losses since equity markets peaked in mid-February, defensive Quality and Low Volatility factors have strongly outperformed riskier Value and Size, accelerating trends in place for the past 12 months. This is shown^[5] in Figure 3.

To the extent that so many aspects of COVID 19 are unprecedented, it is clearly too early to say, with any confidence, whether factor performances will behave as they have on the road out of previous recessions.

Factor performance in Australia and across regions

Different markets with different structures, economies, and populations tend to support the performance of different factors. Figure 4 shows^[6] how different these returns can be. Size, Value, and Momentum all work to some extent in the US (the source of much factor research), but this is not the case for other markets around the world. In Germany, for example, Size has returned -5% annually since 1987, whereas in Japan, Value has been the best performing factor.

In Australia, Momentum and Value stocks have excelled.

Several experts have observed^[7] how Australian factors don’t necessarily behave like the rest of the developed world, and there are several possible explanations for this, including the fact that our equity market is relatively more concentrated (the largest stock in the ASX 300 accounting for a much higher proportion of total index value than seen in other markets), the tendency of Australian companies to pay higher dividends and our higher weighting towards financials.

Macro-economic effects, such as commodity prices and the acceleration of GDP growth in China, are also likely to have a bigger impact on Australian equities than other equity markets.

Factor definitions – when simpler does not equal better

Simplistic factor definitions typically used in generic factor strategies may be suboptimal if they lead to significant exposures to unrewarded risks. In this regard, efficiently capturing factor premia requires robust, enhanced factor definitions which address potential issues.

The Value factor, for example, is premised on the tendency of inexpensive securities, relative to their fundamentals, to outperform over the longer term. The pitfall in an overly simplistic approach here is that some ‘cheap’ stocks may be cheap for very good reason.

Whilst prominent academics, such as Fama and French, have argued^[8] that the

Value premium is a compensation for risk, in particular distress risk, research by Robeco⁹ found no such linkage, arguing that it is not necessary to take on distress risk to profit from the Value premium. Figure 5 illustrates clearly that high-risk Value stocks identified using different measures of distress risk, do not achieve higher returns than low-risk Value stocks.

While conventional Value strategies are typically exposed to distress risk, Robeco’s research findings prove it is therefore possible to design a value strategy that explicitly avoids financially distressed firms. In other words, that avoids buying stocks that are cheap for good reasons.

Similarly, the Momentum premium is one of the largest factor premia, but its sensitivity to market reversals and high turnover are two well-known issues that can challenge the implementation of an efficient strategy. A focus on stock-specific momentum can considerably reduce the general market reversal risk seen in conventional Momentum strategies, whilst tempered trading patterns can help contain costs.

Generic Low Volatility strategies are often based on a single backward-looking historical risk measure, such as volatility or beta. This construction, however, may expose the strategy to some pitfalls, such as miscalculated downside risk. Not all Low Volatility stocks are equal and some are destined to perform better than others. This is especially true when they become expensive.

A more sophisticated approach can overcome these issues, by taking a multi-dimensional view of risk. This means using several low-risk variables, that include both long- and short-term statistical data. This also means taking into account backward- and forward-looking measures of risk^[10], such as changes in a company’s capital structure or credit default indicators.

These elements have a more forward-looking nature and helps to avoid investing in companies that have a high probability of going into default. For example, Figure 6 shows how distance-to-default, a measure of distress risk, was a much better predictor of Lehman Brothers’ problems in the run-up to its bankruptcy than its stock’s three-year volatility.

An oft-cited downside with generic Quality strategies is their use of use poor definitions. Traditional industry Quality measures such as earnings growth and stability and ROE have actually been shown to have weak or no predictive power. More academic-based Quality definitions tend to be more multi-dimensional, incorporating governance and management indicators as well as earnings quality measures.

Factor strategies work in credit markets too

Whilst most of the focus, activity, and research relating to factor investing relates to its application in equity markets factors, the rationale behind the ‘core’ investment factors are not asset class specific, and factors have also been observed in credit markets, currency markets, commodities and even real estate. Figure 7 illustrates the outperformance of factors in credit markets between 1994 and 2017.

There is increasing interest in applying factor strategies to credit markets, undoubtedly spurred on by the results achieved in equity markets, and the growing body of academic work in this area. One example of such work is ground-breaking paper ‘Factor Investing in the Corporate Bond Market’ by Patrick Houweling and Jeroen van Zundert^[11]. Their paper reports extensive empirical evidence that factors similar to those used in equity markets generate economically meaningful and statistically significant alphas in the corporate bond market.

Notwithstanding this evidence, the use of a factor-based approach in credit markets is not without challenges.

When it comes to government and corporate bond indices, for example, high index weightings are assigned to the most highly indebted countries and companies, meaning investments made in line with market capitalisation will be disproportionately invested in issuers with the highest debt burden (as opposed to those with the best ability to repay).

Furthermore, credit indices can be less balanced than equity indices, with many global government bond indices having a strong US and Japanese bias, while many corporate bond indices primarily contain bonds from the financial sector.

How to efficiently harvest factor benefits

Whilst our earlier article^[12] noted the incremental lift in portfolio performance when multiple factors were used – as opposed to single factor strategies – there are certainly circumstances where a single factor approach is appropriate. One example is the incorporation of a single factor into an existing portfolio to achieve a specific goal, such as lowering volatility.

Regardless of whether a strategy is based on single or multiple factors, it is critical to understand the cross-relationships – positive and negative – that may exist between some factors at various times. For example, a Low Volatility strategy may have a negative relationship with Value where such stocks are expensive. Similarly, a Quality stock can have reverse momentum.

Efficient factor strategies are designed in such a way that premia do not clash with each other. Combining factors in a portfolio needs to reflect these potential factor cross-effects, and take a more holistic approach, likely reflected in more dynamic, tailored weighting of factors within a portfolio, rather than a more equal, simplistic, ‘naïve’ weighting. Figure 8 illustrates the extent to which more holistic – less naïve – approach to combining factors can improve the prospects for a portfolio to outperform¹³, as well as highlighting typical cross factor relationships.

A word about ESG

Growing demand for sustainable investment solutions means asset managers are increasingly expected to take ESG criteria into account in their investment processes, without sacrificing returns.

Factor-based strategies are particularly suitable for smart sustainability integration.

Their rules-based nature makes it relatively easy to integrate additional quantifiable variables in the security selection and portfolio construction process. From this perspective, a factor-based approach that integrates sustainability aspects in the investment methodology is not very different from a standard factor-based approach, where securities are included in a portfolio solely based on their factor characteristics.

Conclusion

The popularity of factor investing continues to grow, driven by sustained outperformance relative to market, and a growing body of academic research proving its effectiveness.

However, harvesting the benefits of factor premia is not without its challenges, and investors need to take into account complex cross relationships between individual factors, and differences in factor behaviour observed across different economic and market cycles, different regions and different asset classes.

The optimisation of a factor-based strategy is also reliant on the robustness of the factor definitions used, and in this respect, investors should be wary of the pitfalls inherent in the simplistic definitions used by many generic factor products.

Rather than sounding a death knell for active management, the imperative to ensure a more integrated, dynamic and comprehensive approach to designing and executing factor strategies suggests there is more opportunity – and indeed more need – for active managers to clearly differentiate themselves from mere factor providers.

There are many different ways investors can access factor investment strategies. Understanding the complexities involved in optimising a factor-based approach and appreciating the benefits and pitfalls of the many options available in the market, will leave Financial Advisers better equipped to help their clients achieve their investment and lifestyle goals.

Read Part one: CPD: Factor investing – an introduction

 ———–

References:
1. https://adviservoice.com.au/2020/06/cpd-factor-investing-an-introduction/
2. Morningstar, Hedge Fund Research (HFR), Morgan Stanley ETF trading desk, Morgan Stanley Research, morganstanley.com/ideas/quant-fundamental
3. ‘Foundational Concepts for Understanding Factor Investing’, B. Warren & S. Quance, invesco.com
4. ‘Where are the factors?’, H. Fremsted, blackrock.com, December 2019.
5. ‘Factors in Focus: Risk sentiment and factor dynamics in a crisis’, H.D. Varsani, W. Virgaonkar, R. Mendiratta, MSCI.com, April 2020.
6. ‘Indexing and Factor Investing’,com.au, February 2018.
7. ‘Australia the odd man out in factor investing’, Michael Hunstad, Investor Strategy News, ioandc.com, August 2015.
8. ‘The cross section of expected stock returns’, E. Fama and K. French, The Journal of Finance, June, 1992.
9. ‘Are the Fama-French factors really a compensation for distress risk?’, W.de Groot and J. Huij, Journal of International Money and Finance, September 2018.
10. ‘How distress risk improves low-volatility strategies: lessons learned since 2006’, J. Huij, P. van Vliet, W. Zhou and W. de Groot, Robeco Research Paper, 2012.
11. ‘Factor Investing in the Corporate Bond Market’, Houweling and J. van Zundert, Financial Analysts Journal, Vol 73, No. 2, 2017.
12. https://adviservoice.com.au/2020/06/cpd-factor-investing-an-introduction/
13. ‘Foundational Concepts for Understanding Factor Investing’, B. Warren & S. Quance, invesco.com

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Academic research and many years of practice have shown that factor-based strategies can help to significantly improve the return-risk profile of a portfolio.

Introduction

Any list of the hottest topics in investment management circles over the last few years is almost certain to contain ‘Factor Investing’.

Sitting between highly active, alpha seeking investing and low-cost, index hugging investments, factor investing is effectively a ‘third pillar of investing’, combining the transparent, rules-based and low-cost nature of passive investing with the outperformance opportunities of active investing.

As such, factor investing strategies are likely to be of great relevance – and value – to financial advisers and their clients.

Factor investing is underpinned by the premise that the performance of a portfolio is often largely attributable to the presence of one or more observable ‘factors’ or characteristics, rather than the skill of the individual fund manager. Examples of these factors – known as factor premiums– include ‘low volatility’, ‘value’, ‘quality’, and ‘momentum’.

Although not without its detractors^[1], the quantitative evidence in support of factor investing is overwhelming, and as a result, factor investing continues to grow in popularity, especially with investors for whom cost and transparency are important.

Indeed, a 2018 study^[2] found that over 70% of institutional investors were using factor strategies, and more than 60% were planning to increase their use of them in the following years. Furthermore, in a report^[3] published in October 2017, Morgan Stanley estimated that almost USD 1.5 trillion were invested in smart beta, quant and factor-based strategies and that assets under management have been growing 17% per year on average since 2010.

The benefits of factor investing are accessible to individual investors too, via a variety of widely available products designed to meet different objectives and which can therefore be tailored to the unique needs of your clients.

But whilst interest in, use of, and discussion about, this third pillar of investing has never been higher, factor investing is no overnight sensation, and the genesis of the factor approach can be traced back more than four decades, to academic studies from the 1970s.

In this article, we will discuss the origins of factor-based strategies and examine in more detail the evolution of specific factor premiums. We will explain the terminology of factor investing as well as exploring the effectiveness of factors in driving performance and risk management outcomes within portfolios.

What is factor investing?

At the heart of factor investing is the identification of discrete and common characteristics which explain differences in returns between equities (and bonds), and which can be harnessed via a rules-based approach to deliver higher returns, greater diversification, and lower risk, over time.

Selecting stocks and building portfolios which exhibit these characteristics – called factor premiums – can add significant value to investors over the longer term.

Whilst the last few decades have seen researchers propose literally hundreds of factors, most of these have not proven particularly robust, and only a relatively small number have achieved universal acceptance and attention amongst experts. Figure 1 below defines the four most widely accepted factors, whilst Figure 2 illustrates the extent to which these factors have been proven to drive out-performance over a five-decade period in the US.

A fifth factor subscribed to by some, but not all, fund managers is ‘size’, based on the
tendency of bonds issued by companies with little debt outstanding, and small-capitalization stocks, to outperform the market.

Although most discussions – including this article – tend to focus on the five ‘style factors’ described above, experts also acknowledge those well-known and intuitive ‘macro factors’ which can influence securities pricing, including economic growth, inflation, and interest and exchange rates.

The academic origins of factor investing

The existence of factor premiums – and their proven ability to explain higher than market returns – was first documented in 1970s and early 1980s, when academics begun to uncover anomalies in the Capital Asset Pricing Model (CAPM) of risk and return.

The CAPM model – the dominant market theorem for a time – posited that the relationship between risk and return was linear. Simplistically it said those securities which were inherently riskier needed to reward investors in the form of higher returns. The model was developed during the 1960s – a time characterised by a relative lack of data and low computing power – and as such was more theoretical than evidence based, assuming, amongst other things, the existence of rational, perfectly informed investors.

By the 1970s the ability to collect and analyse data was increasing, and several studies were released which showed the CAPM risk/return relationship was much weaker than had been previously accepted, and that other ‘factors’ were in fact responsible for driving investment performance differences.

A brief chronology of these first studies – and the factors they effectively introduced to the world – is shown below.

1972 – low volatility

A Robert Haugen and A. James Heins study^[4] showed that less volatile stocks had consistently outperformed more volatile ones over the 1929-1971 period. (Note: whilst this study was based solely on US stocks, Robeco’s David Blitz and Pim van Vliet showed in their award-winning paper^[5] from 2007 that this also held true across Europe and Japan).

1977 – value

Sanjoy Basu observed and documented^[6] the value factor for the first time in 1977. After ranking stocks according to their price-earnings ratio, Basu found an inverse relationship between the price-earnings ratio of a stock and its return. In other words, stocks featuring a lower valuation tended to achieve higher returns than the CAPM would suggest.

1981 – size

A study by Rolf Banz^[7] identified that shares in smaller companies tended to outperform those of larger companies.

1993 – momentum

Jegadeesh and Titman ‘discover’ the momentum factor^[8], based on the premise that the outperformers of the recent past are seen as the outperformers of the future. Momentum can be in share price and earnings.

1993 – Fama and French three factor model

In essence a synthesis of the various earlier studies already described, Nobel Prize winning economist Eugene Fama^[9] and his researcher Kenneth French proposed the ‘three factor model’, within which asset pricing was shown to be a result of the interplay between three factors; size, value, and market risk.

Unhappy Norwegians – the real-world catalyst for factor investing

As strong as the academic underpinnings of factor investing had been, they remained largely ignored by most investors for several years.

The breakthrough for factor investing came after the 2009 publication of a research report^[10] analysing the performance of one of the world’s largest sovereign wealth funds, NBIM, which invests Norwegian oil revenues. Although famed for being one of the happiest nations on earth^[11], the GFC had seen the NBIM lose 23% in value during 2008, leaving the fund’s managers distinctly unhappy!

To understand exactly why the fund had performed the way it had, NBIM management commissioned a study by high profile business academics Andrew Ang, William Goetzman and Stephen Schaefer. Their study showed that approximately 70% of all active returns (alpha) since NBIM’s inception in 1998 could be explained by implicit exposures to factor premiums and therefore did not reflect true investment management skill. The analysis also highlighted that these factor exposures were merely a by-product of the bottom-up security selection by the active managers NBIM had hired and not a deliberate investment decision.

The authors recommended NBIM to begin using a top-down approach to intentionally obtain strategic factor exposures and to examine how the individual factor premiums could be harvested in the most efficient manner. After this research was published, strategic allocation to factor premiums was dubbed by some as ‘the Norway model’.

Escaping the zoo – what makes a factor?

In recent years, the combination of rising computing power and greater data availability has led to a dramatic rise in the number of market anomalies reported by academics. Purported factors have become so numerous that a number of experts have characterised their ubiquity as a factor ‘zoo’^[12].

However, many of these factors subsequently prove to lack robustness, either because they are nothing more than different ways of measuring the same phenomenon, or because they only work over short periods of time or in limited market segments.

Most experts agree that that it is possible to bring the number of anomalies included in the zoo down to a handful of relevant factors, which consistently perform over multiple time periods and across markets.

According to Robeco, one of the pioneers of factor investing, a factor should meet the following criteria to be regarded as relevant:

1. Performing: show strong premium with superior risk-adjusted returns;
2. Proven: surmounted attempts for falsification (within academia and in-house research);
3. Persistent: observable in different markets, stable over time, robust to different definitions;
4. Explainable: have an economic rationale with strong academic underpinnings;
5. Executable: implementable in practice; e.g. survive after trading costs and other market frictions.

Investing via factor-based strategies

In general, a portfolio diversified along factor lines can reduce risk and enhance return potential over the longer term when compared to the broader market. The rules-based approach to generating superior performance is generally achieved at a lower cost than traditional active management.

Investors can access factor investment strategies – which can be active, or index based – in many different ways and can use them to accomplish a range of objectives, spanning high level objectives such as return enhancement, cost and risk reduction, and diversity, as well as more specific objectives in areas such as income generation, ESG integration and regulatory obligations.

Improving returns

As already illustrated in Figure 2, above, there is a substantial body of evidence proving that stocks exhibiting value, momentum and quality factor characteristics achieve higher returns over the longer term. This has also proven true for corporate bonds with attractive value, momentum and size factor characteristics, as shown in Figure 3 below.

Lowering risk

The low volatility factor is grounded in empirical evidence that securities generating stable returns relative to the broader market have achieved higher risk-adjusted returns than riskier ones over the longer term^[13]. Various studies have confirmed this effect holds true in equity markets across the world and also in other asset classes, in particular the corporate bond market.

Increasing diversity

Diversification is one of the most fundamental risk management principles, and asset owners have long applied this principle by dividing their holdings across different asset classes and regions. But the dramatic increase in correlations between asset class returns during the market turmoil of the 2000s cast doubt on the benefits of traditional diversification frameworks, and many investors have turned to factor investing in the quest for more robust diversification techniques.

Various empirical studies have demonstrated the superior diversification benefits of factor investing, compared to classic diversification.

For instance, a 2012 paper^[14] by Antti Ilmanen and Jared Kizer analysing data on several asset classes dating back to 1927 reported that diversification into and across factors has been much more effective in reducing portfolio volatility and market directionality than traditional asset class-based approaches

Smart beta

One popular way to accessing the proven benefits of factor investing is via index-based factor strategies, known as ‘smart beta’. Smart beta strategies explicitly target factor premiums and represent an alternative to traditional market capitalization-weighted indices (beta).

Motivations to use smart beta and factor strategies

A 2019 survey^[15] of European investment professionals, conducted by EDHEC Risk Institute, found the most important motivation behind the adoption of smart beta and factor investing strategies is to improve performance. On a scale from 0 (no motivation) to 5 (strong motivation), respondents gave an average score of 3.76 to ‘Improve performance’. ‘Manage risk’, which is in second position among key motivations (score of 3.25), is also an important element of choice when it comes to smart beta and factor investing strategies (see Figure 4).

Single factor v multi factor

Another key decision for factor investors to make is whether to invest in a specific factor (a single factor ‘tilt’) or across multiple factors. As always, the answer is very much dependent on the investment objectives being pursued.

Value strategies are a good example of how single factor strategies are neither unusual nor new. For decades, prominent investors have advocated buying securities trading below their intrinsic value and many active managers have been offering so-called value strategies^[16]. With the advent of factor investing, many investors have turned towards this kind of approach, as a systematic and cost-efficient way to achieve the kind of exposures they were previously seeking with ‘fundamental’ strategies.

Notwithstanding the legitimacy of single factor strategies however, there is a strong body of evidence suggesting that multi-factor strategies are particularly effective.

A research paper^[17] by Joop Huij and Eduard van Gelderen analysed the returns of US equity mutual funds over the 1990-2010 period and found large differences between the funds with significant exposure to one or more proven factors and those without factor exposures. Only 20% of the funds with no exposure to factors yielded outperformance (relative to the market) in the long run. For funds that did have significant exposure to proven factors, this figure was substantially more favourable, ranging from 51% for single factor funds to 68% for two-factor funds, and 78% for three-factor funds.

Assisting, not replacing, active managers

Rather than undermine the importance of active management, factor investing should be thought of as adding to the investors’ armoury and would typically be an approach used alongside other strategies.

In this regard, the aftermath of the previously discussed NBIM Fund report is instructive.

Remembering that the initial report found that 70% of fund performance could be attributed to factor premiums, the impact of active investment management was therefore still recognised as substantial.

Subsequent to this report, the NBIM Fund adopted a formal factor-based investing approach based on size, value and growth factors. A follow-up report^[18] noted that the Fund’s factor approach became just one facet of a multi-pronged approach, which also included security selection by way of external active managers and internal programmes.

Put another way, the cost and effort savings accrued from applying a factor-based strategy can be re-directed towards seeking truly complementary active management to harvest returns from specific investment insights and idiosyncratic risk, thus helping achieve even higher performance.

The future

Whilst the empirical evidence supporting the efficacy of factors is substantial, our understanding of factors continues to evolve, in line with an ever-growing data set, and increasingly sophisticated- AI based – data mining techniques.

Research continues apace, and whilst the factor zoo continues to welcome – then farewell – many exotic new species, most studies subsequent to those seminal works discussed earlier have strengthened the basis for the core factor premiums, reinforcing their robustness.

Notwithstanding this, not all factors are created equal, and some have proven more powerful than others over specific time periods and in different regions of the world.

Real world, once in a lifetime, events such as the Covid 19 pandemic will continue to challenge and inform our understanding of investment markets. But whilst the exact impact of Covid 19 is yet to be fully understood, the intellectual basis for factor premiums is built on a global data set spanning the Great Depression, two world wars, the Spanish Flu, the GFC and multiple tech-bubbles, and as such, investors should be confident in their continued value and relevance in an increasingly complex world.

Conclusion

Academic research and many years of practice have shown that factor-based strategies can help to significantly improve the return-risk profile of a portfolio, for example by reducing downside risk or enhancing long-term returns. As a result, the popularity of factor investing continues to grow.

Factor-based strategies can be active or passive and are easily accessible to individuals via a variety of products which can be tailored to meet each investor’s unique objectives.

Financial Advisers who understand the academic basis of factor investing, and the options available to access a factor-based strategy, either as a standalone approach or to complement other strategies, will be much better equipped to help their clients achieve their investment and lifestyle goals.

Read Part two: CPD: Factor investing in action, across regions, cycles and asset classes

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References and notes:
[1] ‘Factor investing – what went wrong?’, Allan Roth, Advisor Perspectives, September 2018.
[2] Invesco Global Factor Investing Study, 2018, invesco.com.au
[3] Morningstar, Hedge Fund Research (HFR), Morgan Stanley ETF trading desk, Morgan Stanley Research, morganstanley.com/ideas/quant-fundamental
[4] Robert Haugen, A. James Heins, Wisconsin working Paper, 1972.
[5] ‘The Volatility Effect: Lower Risk Without Lower Returns’, D Blitz and P. van Vliet, Journal of Portfolio Management, Fall 2007.
[6] ‘Investment performance of common stocks in relation to their price-earnings ratio: a test of the market hypothesis’, S. Basu, The Journal of Finance, 1977.
[7] ‘The relationship between return and market value of common stocks’, Rolf. W. Banz, Journal of Financial Economics, 1981.
[8] ‘Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency’, N. Jegadeesh and S. Titman, The Journal of Finance, March 1993.
[9] ‘The cross section of expected stock returns’, E. Fama and K. French, The Journal of Finance, June, 1992.
[10] ‘Evaluation of Active Management of the Norwegian Government Pension Fund – Global’, A. Ang, W. N. Goetzman, and S.M. Schaefer, December 14, 2009.
[11] “World Happiness Report,” http://www.worldhappiness.report
[12] John Cochrane of the University of Chicago coined the term “zoo of factors” in his 2011 presidential address to the American Finance Association.
[13] ‘The Volatility Effect: Lower Risk Without Lower Returns’, D Blitz and P. van Vliet, Journal of Portfolio Management, Fall 2007.
[14] ‘The Death of Diversification Has Been Greatly Exaggerated’, Ilmanen and J. Kizer, The Journal of Portfolio Management, Spring 2012.
[15] The EDHEC European ETF, Smart Beta and Factor Investing Survey, www.risk.edec.edu, September 2019.
[16] See for example: ‘Security Analysis’, Benjamin Graham and David Dodd, 1934.
[17] ‘Academic Knowledge Dissemination in the Mutual Fund Industry: Can Mutual Funds Successfully Adopt Factor Investing Strategies?’, E. van Gelderen and J. Huij, The Journal of Portfolio Management, 2014.
[18] ‘Review of the Active Management of the Norwegian Government Pension Fund Global’, A. Ang, M. W. Brandt, D.F. Denison, 20 January, 2014.

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Tracing its origins back several centuries, Sustainable Investing is an important and growing part of the global investment landscape.

Introduction

In the previously published first article of this two-part series (‘Sustainable investing, concepts, considerations and conversations’), we introduced the topic of Sustainable Investing (SI), focussing on the different types of SI, its origins, and growth drivers. In this second part we will take a closer look at Sustainable Investing in action in Australia, including the regulatory framework, the nature of active investment, and performance track record of funds managed under SI principles. We will also bust some of the most common SI myths.

Sustainable Investing – a brief recap

Tracing its origins back several centuries, Sustainable Investing is an important and growing part of the global investment landscape. Driven by several factors, including the growing impact of climate change and increasing regulatory oversight of areas such as governance, corporate culture and supply chain management, socially aware investors are placing more emphasis on the SI credentials of investment vehicles.

For our purposes, SI is not confined to ethical investing, but rather refers to a more comprehensive approach to investing which ultimately views environmental, social and governance (ESG) considerations through a financial lens, quantifying risks and taking a long-term view.

As depicted in Figure 1 below, we define Sustainable Investing as comprising three core approaches: exclusions, ESG integration, and impact investing. More detail on each of these approaches can be found in our earlier article.

Sitting beneath these umbrella SI approaches are a number of specific strategies, including negative and positive screening, thematic sustainable investing, and active ownership (a strategy we will examine in more detail later in this article).

Sustainable Investing is now the dominant approach, and it is still growing

Far from being a niche category, SI is becoming a dominant approach globally.

In 2018 it was estimated^[1] that more than $30 trillion USD were managed according to SI principles around the world, representing growth of 34% over the previous two years.

Furthermore, the Global Sustainable Investment Review estimated^[2] that in 2018 more than 60% of funds under management in Australia and New Zealand and half of FUM in Europe and Canada were being managed in this way.

Breaking this down by approach, ESG integration is by far the most used common strategy, although negative screening is also gaining traction, as can be seen in Figure 2 below^[3].

Active ownership

Shareholders in a business are owners of that business, and increasingly investors are using this ownership power to influence how firms are run in order to protect or enhance their investments. This kind of ‘active’ ownership is now at the forefront of Sustainable Investing, and in Australia it is estimated around one third of sustainable investment managers are employing active ownership strategies^[4].

Whilst for some the term ‘shareholder activism’ conjures negative images of small groups of investors wielding disproportionate amounts of power, disrupting shareholder meetings and pursuing social causes, the reality of active ownership, particularly in Australia, is more about ongoing corporate engagement, with a particular focus on governance issues.

The two main types of active ownership are corporate engagement and shareholder voting.

Corporate engagement

Corporate engagement is the process of entering into a formal dialogue with those companies that are seen to have sustainability issues that could affect their future performance and value.

Engagement can be on issues across the environmental, social and governance spectrum, and whilst perceived governance failures are undoubtedly a major driver of investor engagement activity, investors have realised that environmental and social issues are also better dealt with through engagement. It is, after all, easier to influence a company’s behaviour by engaging with it than by excluding it or divesting it from a portfolio. Divesting thermal coal producers, for example, may make a portfolio more sustainable, but it has no effect on achieving decarbonization overall. Instead, investor efforts have focused on trying to persuade fossil fuel producers to change business models and switch to renewables.

Shareholder voting

One of the most powerful points of leverage investors have in terms of exerting influence over the direction of a company is of course their ability to vote against that company’s policies at shareholder meetings.

While individual shareholders with only a small percentage of the stock may not be able to make a difference unilaterally, many investors now band together to create a more powerful, collective force of influence. This has been seen in the growth of investor associations, who often use a sophisticated approach to gathering voter proxies, giving them the power to be heard on bigger issues.

For Australian shareholders, executive remuneration is a particularly important topic, and one on which legislation affords them significant power via the ‘two strikes rule’.

Under this rule, introduced in 2011, if shareholders vote down a company’s executive remuneration package two years in a row, the board may be voted out of office. Even if voting against it does not immediately curtail the pay levels at a company, it has proven very effective in creating enough reputational damage or embarrassment for companies to ensure action is eventually taken.

Two well-publicised Australian examples of remuneration strikes are AMP, who in 2018 became the first ASX 50 company to record a remuneration strike^[5] (in the midst of the Hayne Royal Commission), and Westpac, who recorded a second strike in late 2019. Whilst Westpac’s shareholders declined the opportunity to spill the board at this time^[6], the associated fallout did cost the CEO and Chair their jobs (as was also the case at AMP).

Whilst Australian corporate law is seen as particularly conducive to active ownership – through the two strikes say-on-pay vote or the ability to call a shareholder meeting pursuant to the Corporations Act – some experts believe that this actually allows institutional investors much better access to boards and senior management, especially at larger companies. This access has in turn allowed Australian investors – relative to their global peers – to use behind the scenes engagement more than the blunt instrument of public shareholder activism, as borne out in Figure 3 below^[7].

Busting the SI performance myth

Despite the obvious – and growing – scale of Sustainable Investing, some legacy misconceptions persist. The most powerful – and pertinent for advisers – is that ESG led investment processes carry a performance penalty.

In fact, there is now plenty of evidence – ranging from academic studies to actual performance data – showing that an SI approach can enhance returns.

The 2015 paper ‘From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance’ by Oxford University and Arabesque Partners^[8] examined more than 200 sources and concluded that “80% of the reviewed studies demonstrate that prudent sustainability practices have a positive influence on investment performance”.

A separate survey later that year by Deutsche Bank’s Asset and Wealth Management division in conjunction with the University of Hamburg went even further^[9]. This research looked at the entire universe of 2,250 academic studies published on the subject since 1970 and concluded that an ESG approach made a positive contribution to corporate financial performance in 62.6% of cases and produced negative results in only 10% of cases (the remainder were neutral).

Actual performance data also bears out these findings, with Figure 4 showing that investments managed under SI principles actually outperform non-SI investments over most time frames and asset classes^[10].

Other common misconceptions about Sustainable Investing

Another pervasive myth is that sustainability is only about green issues. While the environment remains important, ESG means focusing on social and governance factors as well.

Issues as diverse as education, energy, food production and supply chains are all important ones for investors to consider (the latter two becoming very top-of-mind during the panic buying seen as a result of COVID-19). Renewable energy is arguably one the biggest business opportunity of our times, and for many this is less about the environment and more about the fact that unsubsidised renewable energy is now most frequently the cheapest source of energy generation^[11].

Meanwhile, a very 21st century misconception is that only millennials are interested in sustainability. While, it is true that younger people are more likely to believe in it more than their parents or grandparents, research referenced in our earlier article showed that more than half of respondents aged 35 – 54 and nearly 30% of those aged 55 and over expected their wealth manager to screen investments based on ESG factors^[12].

ESG in action case study – CSL

If ever a company deserved the accolade ‘market darling’, it would be CSL.

When assessed purely from a shareholder return perspective, it is an absolute standout, and after years of consistent profit growth it has surpassed the major banks and miners to become the largest in terms of ASX market capitalisation.

Yet as a story in the AFR^[13] alludes to, even CSL – who specialises in the collection and supply of blood plasma – is finding itself under intense scrutiny by analysts who are pricing in a degree of ESG risk, related to the way the company solicits blood donations.

Specifically, there are questions about whether donations – for which donors are paid are concentrated in more disadvantaged areas. This raises both financial and reputational risks. Should such activities be seen to be exploitative, possible scenarios could include CSL ends up paying more to donors, or there being a crackdown on migrant donors, or the maximum donations per year being lowered. All of which would have the effect of raising costs.

Whilst CSL flatly rejects any suggestion that its practices are exploitative – and most experts agree with them – the story does illustrate that ESG considerations are much broader than ‘green issues’, and they can be absolutely financially material.

The Australian regulatory framework for SI

The global nature of investment markets sees investors operate across a range of complex and ever-changing social and regulatory frameworks.

From an SI perspective, the main architects of the framework in Australia are the Federal Government, along with ASIC and APRA – who drive a lot of the detail – and the various industry associations who help provide vital market feedback and input into an evolving set of rules and regulations.

Of particular relevance to the topic of SI is the legislative landscape in areas such as climate change, labour exploitation, resource degradation, energy and education, and some of the evolution in Australian laws in these areas relates, directly or indirectly, to Australia fulfilling its commitment to the 17 Sustainable Development Goals (SDGs) adopted by the United Nations General Assembly in 2015.

One high profile example is the Modern Slavery legislation, which came into effect in Australia at the start of 2019, and which other G20 countries – including the UK ­- have also put in place.

Owing much to the highly publicised ‘sweatshop’ scandals which enveloped global fashion brands such as Nike over a decade ago, the intent of this legislation is to force companies – across all industries – to examine their supply chains and eradicate any reliance on ‘slave’ labour by any of its suppliers.

Much of ASIC’s work and guidance around sustainability has focused on climate risk, and the extent to which companies disclose the nature and quantum of that risk to investors and other stakeholders.

In September 2018 they released Report 593, an examination of climate risk disclosure by Australian listed companies. High-level recommendations set out in that report included companies adopting a proactive approach to emerging risks, including climate risk, and the development and maintenance of strong and effective corporate governance which helps in identifying, assessing and managing risk.

In August 2019, ASIC followed up Report 593 by announcing^[14] updates to two Regulatory Guides, 228 and 247. These updates included:

• RG 228 (Prospectuses: Effective disclosure for retail investors) – updated to incorporate the types of climate change risk developed by the G20 Financial Stability Board’s Taskforce on Climate Related Financial Disclosures (TCFD) into the list of examples of common risks that may need to be disclosed in a prospectus; and
• RG 247 (Effective disclosure in an operating and financial review) – updated to highlight climate change as a systemic risk that could impact an entity’s financial prospects for future years and that may need to be disclosed in an operating and financial review (OFR).

APRA’s view and intentions in this space were clearly articulated back in 2017, by Executive Board member Geoff Summerhayes:

“The days of viewing climate change within a purely ethical, environmental or long-time frame have passed…… Some climate risks are distinctly ‘financial’ in nature. Many of these risks are foreseeable, material and actionable now. Climate risks also have potential system-wide implications that APRA and other regulators here and abroad are paying much closer attention to.”^[15]

In February 2020, APRA sent a letter^[16] to all APRA-regulated entities outlining plans in a number of areas. These plans included the development of a new climate-related financial risk prudential practice guide, and the updating of superannuation Prudential Practice Guide SPG 530 Investment Governance (which includes sections relating to environmental, social and governance (ESG) investments). They also announced their intentions to conduct a climate change financial risk vulnerability assessment in 2021.

To the extent that ESG considerations are now identified as core business risks with material financial implications, such guidance is eagerly sought by many stakeholders, not least the board of directors who can be held liable for breaching their legal duty of due care and diligence if they don’t afford such risks due consideration.

Elements of self-regulation are also common across the Australian financial sector, with relevant examples in SI being the Australian Asset Owner Stewardship Code, to which many members of the Australian Council of Superannuation Investors (ASCI) are signatories, and the FSC Standard on Asset Stewardship.

Stewardship principles include active ownership by asset owners and asset managers over investment assets, with signatories to the ACSI Code committing themselves to activities including monitoring assets and service providers, engaging with companies and holding them to account on material issues, and voting and publicly reporting on the outcomes of these activities.

Guidance specific to financial advisers

Although there are not currently any specific legal requirements for advisers to explicitly address ESG matters with their clients, there are several relevant pointers to be found across various Acts and Regulatory Guides.

Section 961B (2) of the Corporations Act sets out various things that an adviser must do to be acting in a client’s best interests including identifying the objectives, financial situation and needs of the client.

ASIC regulatory guide 175 provides further guidance on how advisers can satisfy their duty to the client.

When it comes to enquiries about the client’s view on sustainability (or ESG factors), RG 175 suggests Advice providers must form their own view about how far s961B requires inquiries to be made into the client’s attitude to environmental, social or ethical considerations:

“Advice providers may need to ascertain whether environmental, social or ethical considerations are important to the client and, if they are, conduct inquiries about them”.  (RG175.311).

The RIAA, in its Financial Adviser Guide to Responsible Investment^[17], suggest that, in order to comply with their legal duty, advisers ought to ask clients a full and comprehensive set of questions including seeking out any sectors they may not be comfortable investing in.

The Guide refers to the EU’s proposal to place a positive requirement on advisers to proactively seek out the sustainability preferences of their clients and suggest that this may become the ‘new norm of knowing your client’.

There seems little doubt that proactive consideration of ESG issues will increasingly form part of the financial advice process, whether mandated or driven by client demand.

Conclusion

Far from being niche, Sustainable Investing is now ‘mainstream’, with formal consideration of environmental, social and governance (ESG) issues becoming common – and often mandatory – practice for businesses across all industries.

This article builds on our earlier partner article – ‘Sustainable Investing; concepts, considerations and conversations’ – to create a comprehensive overview of the Sustainable Investments category.

Having previously explained the origins of SI, the size of the SI market and its growth drivers, as well as the different SI strategies, this article takes a more detailed look at Sustainable Investing in action in Australia, including the evolving regulatory framework and the nature of ‘active’ investment. We also address some of the most common SI misconceptions and prove beyond doubt that SI practices tend to enhance – rather than dampen – investment performance.

An understanding of the concepts covered across both articles will better equip advisers to respond to the increasing market interest in Sustainable Investing, allowing them to facilitate advice outcomes which can meet both the ethical and financial objectives of their clients.

Read more about sustainable investing: CPD: Sustainable investing – concepts, considerations and conversations

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References:
1. Global Sustainable Investment Alliance 2018 Review.
2. Ibid.
3. Responsible Investment Benchmark Report, 2019 Australia, Responsible Investment Association Australasia.
4. Ibid.
5. ‘Shareholder Activism in Australia: a force for good?’, www.financierworldwide.com, October 2018.
6.  ‘Westpac cops second strike on pay, but shareholders decline to spill incompetent board’, David Chau, www.abc.net.au, 12 December 2019.
7.  ‘Easy does it: Shareholder activism in Australia’, Michael Chandler, Sovereign Governance Advisory, Listed@ASX, Summer 2019/2020.
8. ‘From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance’, Clark, Gordon L. and Feiner, Andreas and Viehs, Michael, March 5, 2015.
9. ‘ESG and Corporate Financial Performance: Mapping the global landscape’, Deutsche Asset and Wealth Management, December 2015.
10. Responsible Investment Benchmark Report, 2019 Australia, Responsible Investment Association Australasia.
11. ‘Renewable Power Generation Costs in 2018’, International Renewable Energy Agency, www.irena.org, May 2019.
12. ‘The culture challenge for HNWIs for the wealth management industry in the information age’, FactSet, 2017.
13. ‘CSL’s ESG conundrum could mean great cost of growth’, Jonathan Shapiro, Australian Financial Review, April 26, 2020.
14. ‘ASIC updates guidance on climate change related disclosure’, ASIC Media Release, www.asic.gov.au, 12 August, 2019.
15. ‘Climate change is a financial risk says APRA’, Alice Uribe, Australian Financial Review, February 18, 2017.
16. ‘Understanding and managing the financial risks of climate change’, www.apra.gov.au, February 24, 2020.
17. Financial Adviser Guide to Responsible Investment, Responsible Investment Association Australasia, www.responsibleinvestment.org

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‘Sustainable’ or ‘Responsible’ investing is now very much part of the mainstream investment landscape.

Introduction

Once considered a niche investment category – or even an indulgence – ‘Sustainable’ or ‘Responsible’ investing is now very much part of the mainstream investment landscape, with more than 60% of funds under management in Australia and New Zealand and half of FUM in Europe and Canada^[1] being managed in accordance with Sustainable Investing (SI) principles. In 2018 it was estimated^[2] that more than $30 trillion USD was managed in this way around the world, representing growth of 34% over the previous 2 years.

Sometimes confused with the more narrowly defined ethical investing (‘investing with a conscience’), SI is a more comprehensive approach to investing which ultimately views environmental, social and governance (ESG) considerations through a financial lens, quantifying risks and costs and taking a longer-term view.

The rapid growth of SI has been driven by many factors, including the massive wealth transfer taking place between boomers and the more socially aware millennials, the increasing public desire to mitigate the global ‘climate crisis’, and more regulator mandated transparency in areas as diverse as nutrition, financial reporting, and manufacturing practices.

And, despite widespread perceptions that sustainable/responsible investing comes at the cost of lower returns, there is a growing body of conclusive quantitative evidence that investments managed under SI principles actually outperform non-SI investments over most time frames and asset classes^[3]. Put simply, Sustainable Investing can genuinely drive better investment outcomes.

Many of these drivers will only become more powerful over time, which is why it is imperative that financial advisers properly understand ESG principles and offerings, consider how to evolve their own business and advice processes accordingly, and equip themselves for increasingly frequent client conversations on this topic.

The genesis of Sustainable Investing

The possession of a social consequence is not a new phenomenon, and history is full of examples of highly impressive and forward-thinking philanthropists. In terms of organisations actually codifying an investment philosophy based on social concerns, one of the earliest recognised examples is the 18th century church, when Quakers refused to invest in anything involved with the slave trade then prevalent in many colonised countries. In the second half of the twentieth century, as the legislation of equality in human rights became (belatedly) more widespread, we saw the beginnings of SI on an international scale in the 1970s with the boycotting of investments in South Africa, in response to the racial inequality of the apartheid regime.

By the late eighties, the concept of sustainability in resources and development was gaining more traction, and in 1987 the United Nations World Commission on Environment and Development – known as the Brundtland Commission – released its landmark report ‘Our Common Future’.

With a mandate to examine ways to strengthen international cooperation on environment and development, the Commission sought to “raise the level of understanding and commitment to action on the part of individuals, voluntary organizations, businesses, institutes, and governments”^[4].

Focussing its attention in the areas such as population, food security, the loss of species and genetic resources, energy and industry, it was this report that coined the term ‘sustainable development’, which it defined as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs”^[5].

With the report putting a responsibility for sustainability on the shoulders of individuals and businesses – not just governments – many corporations started to evolve their practices, and in the 1990s entrepreneur John Elkington^[6] was the first to articulate the concept of the ‘triple bottom line’; people, planet and profit. In this framework businesses assessed their performance in each of these areas, recognising a focus on all three was vital to their own sustainability as a business.

Over the last two decades, the triple bottom line concept has given rise to a plethora of responsible business models, frameworks, and operational methodologies, including ESG, an approach which arguably forms the bedrock of most Sustainable Investment processes.

Different approaches to SI

Demand for sustainably managed investment offerings is growing strongly (in Australia SI managed assets grew 13% in 2018^[7]) and reflects a diverse range of motives held by investors.

An individual investor may want to follow their personal beliefs in not wanting to invest in contentious things; they may want to use SI as a means of improving their risk/return profile; or they may like the idea of contributing towards positive change in society.

Rather than being a ‘one size fits all’ philosophy, Sustainable Investing should therefore be thought of as an umbrella concept which reflects all these motivators.

For our purposes, we define SI as comprising three core approaches

• Exclusions;
• ESG integration; and
• Impact investing.

Exclusions

Perhaps the oldest and easiest way to engaging in SI is by refusing to invest in a company that has controversial business practices. Such practices may range from business activities deemed to be harmful to health or the environment, such as tobacco or mining, to outright criminal behaviour such as corruption or forced labour.

The relevance and application of exclusions has become more widespread as economies and investment opportunities have become more globalised and we become more aware of the practices and attitudes that different cultures and societies deem acceptable or not (think Japanese whaling or third world ‘sweatshops’).

Many exclusion-based strategies avoid investing in firms involved in the so-called ‘sextet of sin’ – tobacco, weapons, alcohol, nuclear power, gambling and pornography. But what is deemed controversial evolves over time. For example, over recent years, it has become more common to exclude thermal coal miners, while some now view sugar as ‘the new tobacco’.

Whilst individuals are motivated to apply exclusions by their own moral/ethical code, for corporate investors the prospect of reputational damage – or put more simply, the fear of looking bad – can also be a reason to avoid investing in something that some groups in society disapprove of. The growth of social media has undoubtedly amplified this risk.

ESG Integration

This is the systematic use of financially material ESG criteria to improve the risk/return profile of investments, and therefore boost performance. Importantly, this approach is integrated into an existing framework that incorporates other – more traditional – metrics and is not used in isolation.

The United Nations Principles for Responsible Investment defines this process as:

“The explicit and systematic inclusion of environmental, social and governance issues in investment analysis and investment decisions. Put another way, ESG integration is the analysis of all material factors in investment analysis and investment decisions, including environmental, social, and governance factors.”^[8]

Key here is ‘financial materiality’ – the factors being considered are not just ‘nice to have’ but have a direct impact on the company’s bottom line. For example, an investor will not just look at factors such as pollution or excessive waste from the perspective of harming the environment. Such behaviour may also have a financial impact on the company, from attracting fines, to raising costs and regulatory risks due to poor resource conservation.

Some examples of ESG attributes used to assess a company/investment are listed below:

ESG integration is usually done in three steps. The first is to identify and focus on the most material issues affecting the company. Then the investor can analyse the likely impact of these material factors on the company’s business model. Finally, this information can be incorporated into the valuation analysis to form a fundamental view.

A big advantage of ESG integration is that it works across all asset classes – it has been proven to work just as well in fixed income markets as in equities and can also be applied to commodity or real estate portfolios. In general, ESG analysis in equities seeks to identify an upside that is not necessarily reflected in the share price, while analysis in bonds seek to expose any downside that may not show up in its credit rating.

Two specific ways of applying ESG analysis to investment decisions are positive screening, which seeks out those securities with higher ESG scores, and Best-in-class which takes this one step further and solely targets companies with the highest ESG scores in a particular sector.

Whilst the best-in-class approach is becoming a popular means of creating sustainability-themed portfolios, it does have the drawback of relying solely on ESG criteria as the only driver of future return.

Impact investing

Impact investing involves making investments with the aim of creating a measurable beneficial impact on the environment or society, as well as earning a positive financial return.

In 2015 the United Nations General Assembly adopted 17 Sustainable Development Goals (SDGs). These goals include the eradication of poverty, clean water and sanitation, gender equality and good health and wellbeing.

Many investors choose to target funds that in some way or other contribute to one or more of the goals. For example, a fund may seek to buy food producers that are investing in healthier and cheaper products (eradicating hunger – SGD 2), or health care companies that are developing vaccines for use in emerging markets (good health and wellbeing, SDG3), among others.

Impact investing has three key components. First, there must be intentionality: an investor is making a deliberate, targeted effort to exert a positive impact. Second, it should generate a positive return on investment; this is not charity. And third, the financial, social and environmental benefits of impact investment should be measurable and transparent.

SI growth drivers

The growth of Sustainable Investing has been driven by many powerful and interconnected global forces. These include megatrends such as climate change and digitalisation, evolving regulatory frameworks, an increased focus on the UN SDGs, and the massive wealth transition that is putting more money – and power – in the hands of millennials.

Climate change

It is important for investors to assess the impact of climate change on asset class return expectations. The most significant physical impacts of climate change will be seen in the second half of this century, but the consequences for forward-looking asset markets may become apparent much sooner. When expectations for climate change are adjusted, the markets and asset prices will reflect these developments, possibly sooner than the physical changes of global warming make themselves felt.

Obvious examples of areas impacted by climate change include resources, energy production, manufacturing and insurance.

Digitalisation

The increasing connectedness of societies and economies is leading to risks of security breaches, data privacy issues and false information. No matter how much companies spend on technical cybersecurity solutions, success ultimately hinges on the judicious and disciplined implementation of cybersecurity policies. Investors therefore need to anticipate both IT spending and organisational culture when assessing the risk profile of a potential investment target.

Evolving regulatory frameworks

Regulatory frameworks around the world are increasingly forcing companies to take a more sustainable approach. In some instances, this is a response to global shocks like the GFC, in others it is to ensure progress towards agreed climate targets or Sustainable Development Goals.

Perhaps the most famous is the Paris Agreement that was ratified by 174 countries on 22 April 2016 – now designated by the UN as ‘Earth Day’.

In financial markets, regulation ranging from Basel III to Solvency II has put in place measures to prevent another global financial crisis, which has changed the ways in which banks and insurers operate. Stewardship codes are becoming increasingly common.

Other initiatives on the way include plans by many governments to force companies to reduce sugar levels in foods to combat obesity, possibly with sugar taxes now being trialled in various countries including the UK and Mexico.

Many countries – including Australia – have adopted modern slavery laws, requiring greater checks in supply chains to root out any child or slave labour, dangerous working conditions or other socially unacceptable practices. And in some countries, exclusions are legally enforceable, such as the Dutch ban on investments in controversial weapons such as cluster bombs.

In some jurisdictions, regulations are also evolving to reflect the increased demand for, and awareness of, ESG issues. In Australia for example, APRA has recently announced^[9] its intention to update superannuation Prudential Practice Guide SPG 530, which addresses the integration of ESG issues into investment processes.

Wealth transfer to socially aware millennials

Meanwhile, a major wealth transition is taking place in which more capital is gradually being controlled by millennials – the generation born since the mid-1980s. Research shows that this cohort have much more interest in investing sustainably than their parents or grandparents – and they will have a lot of money to play with. Millennials will inherit up to USD 59 trillion between now and 2060, creating the largest intergenerational wealth transfer in history, according to the Center on Wealth and Philanthropy at Boston College.[^10]

In Australia, this transfer has been estimated at AUD 3 trillion^[11].

Morgan Stanley’s 2017 ‘Sustainable Signals’ report found that millennials are twice as likely as other investors to want to contribute to a better world as well as make a financial return. “A younger generation of investors, who overwhelmingly believe that their investment decisions can make an impact, is leading the sustainable investing charge,” it said.^[12]

These attitudinal differences between generations are summarised in the graph below, based on 2017 research by Factset^[13].

Adviser considerations and implications

For financial advisers, the growing interest in Sustainable Investing philosophies has a number of important implications and considerations.

1. As advisers engage with more and more millennial clients, they will encounter more interest in SI philosophies and demand for SI products;
2. Rather than being a niche investment category, SI is mainstream, with the majority of professionally managed investments in Australia are managed in accordance with SI principles;
3. The ubiquity of SI reflects not only increasingly powerful social and regulatory factors, but also the superior investment returns achieved by funds managed sustainably;
4. Rather than SI being a homogenous, one size fits all framework, SI should be thought of as an umbrella concept, under which sit several different approaches;
5. These approaches reflect the diverse range of motives – including ethical concerns – that drive individuals to invest sustainably.
6. Advisers should identify whether there are any gaps between increasing demand for SI offerings on the part of their clients, and the extent to which these offerings are understood and available for client consideration.
7. Any regulatory guidance around consideration of SI issues in line with growing investor demand for – and awareness of – SI offerings should also be considered.

In summary, a growing desire to make a positive impact on the planet exists at all levels, government, business and individual. As the momentum behind Sustainable Investment continues to grow, financial advisers have an ideal opportunity to engage with both new and existing clients, helping facilitate outcomes which can meet both ethical and financial objectives, and adding a new dimension to the value of their advice.

Read more about sustainable investing: CPD: Sustainable Investing in action in Australia

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References:
1.Global Sustainable Investment Alliance 2018 Review.
2.Ibid.
3. Responsible Investment Benchmark Report, 2019 Australia, Responsible Investment Association Australasia.
4. ‘Our Common Future’, The Brundtland Commission, United Nations, 1987.
5. Ibid.
6. ‘Enter the triple bottom line’, John Elkington, 2004, johnelkington.com
7. Responsible Investment Benchmark Report, 2019 Australia, Responsible Investment Association Australasia.
8. ‘What is ESG integration?’, United Nations Principles for Responsible Investment, April 2018, unpri.org
9. ‘Understanding and managing the financial risks of climate change’, February 2020, apra.gov.au
10. Boston College, Center on Wealth and Philanthropy, bc.edu/research/cwp.html
11. ‘Social responsibility a top priority for millennial investors’, Killian Plastow, The New Daily, January 2020.
12. ‘Sustainable Signals’, Morgan Stanley, 2017, https://www.morganstanley.com/ideas/sustainable-socially-responsible-investing-millennials-drive-growth.html
13. ‘The culture challenge for HNWIs for the wealth management industry in the information age’,Factset, 2017, https://advantage.factset.com/smart-wealth-management-ebook

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